The Legal Structure Of Chinese Stock Frauds

Every exchange-listed Chinese company that committed fraud in Hong Kong, Singapore, New York, London or Frankfurt had the same legal structure. The exchange-traded company was incorporated in the Cayman Islands, Bermuda, British Virgin Islands (BVI), Singapore, Jersey, Nevada or Delaware. These offshore entities were then used as holding companies for the China-incorporated subsidiaries. Or the exchange-traded offshore entities held other offshore companies, which in turn held the subsidiaries incorporated in China. And some of these offshore companies were reverse merged into US-listed companies incorporated in an American state.

These legal setups provide full protection to Chinese mischief and none to foreign investors. If the Chinese are allowed to take advantage, they will, as can be witnessed by reviewing the delistings since 2001. The "China concepts stocks" delisted from Hong Kong, Singapore and the US in the last ten years had these legal setups. Thus, if an exchange-traded company has this legal setup, more likely than not, the Chinese managers are committing fraud to some extent.

It is important to note that not every Chinese company listed in American markets is of the reverse merger category. Offshore companies are listed in American exchanges as well. To make it very clear, have a look at the following sample of US-listed Chinese companies classified according to its place of incorporation:

All of the Nevada- or Delaware-incorporated companies listed above "reverse merged" a company incorporated in the BVI.

That being said, shareholders who own shares in a Chinese company trading in Hong Kong, Singapore, New York or London may not own an economic participation in the China-incorporated subsidiary because the holding company could have been stroke off its share register and replaced with the name of the Chinese manager or his newly incorporated Chinese company, which would have no relationship whatsoever with the exchange-listed holding company.

Even if the holding company appears as the shareholder of the Chinese subsidiary, it is possible that, unbeknownst to shareholders of the publicly traded company, such shares have been placed as collateral for, say, a personal loan to the Chinese manager. In other cases, the land or fixed assets of the Chinese subsidiary may have been hypothecated by the Chinese manager in order to obtain a personal loan, or a loan for his newly incorporated Chinese company.

To ensure that Chinese subsidiaries are owned by the holding company, their share registers at the State Administration for Industry and Commerce (SAIC) could be checked frequently. In addition, checks on local shares, fixed assets, and land could be performed to ensure that they are mortgage free. Of course, frequent checks will help alert an investor of potential irregularities, but they won't protect him from fraud once such actions have been committed.

By the way, it is helpful to be aware of the many indexes that track the stock price performance of Chinese companies. The most useful are: